‘Magic Numbers’ And Relative Valuations

Many people seem to believe that there are some magic numbers out there that equate to stock-picking success. I hear two things in particular when I’m helping people with their screening strategies: P/E Ratios and Price/Book Values.

For some reason, many people believe that P/E Ratios of 20 or less and Price/Book Values of 1 or less are these so-called magic numbers.

Unfortunately, statistics prove otherwise.

Looking at the best-performing stocks of 2007, (as qualified by stocks that were trading at $5 or higher at the beginning of the year, traded on average of 50,000 shares a day and that have increased in price by 50% or greater by the end of the year) only 47% started with P/Es (using 12 mo. EPS Actuals) of under 20 while the other 53% were over 20.

The point is, if you limited yourself to only those stocks with P/Es under 20, your screen would have kept more than half of the best-performing stocks off of your radar screen. That’s a big deal.

Sure, there were/are stocks in there with P/Es under 20, but you would’ve missed a lot of fantastic winners by excluding those over 20.

And since only 21% had P/Es under 20 by the end, you would have likely been kicked out of even more as they were moving up.

As for the Price/Book Value, the median P/B was 3.07 at the beginning of the period and 4.32 (that’s right, over 4!) by the end. Percentage wise, only 1% of the stocks had P/Bs of less than 1 at the start. That means using the ‘magic number’ of 1 for a P/B value would have excluded nearly every top performer of 2007.

So if you’re determined to look for stocks with ‘low’ valuations (P/E, P/B), try looking for ‘low’ valuations as compared to their Industries.

Why? Because 67% of the stocks on that list of winners had P/Es under the average for their Industry and over 74% had P/Bs under the average for their Industry –- meaning the majority of the best companies would have made it through a relative valuation screen, giving you a chance to buy them.

So instead of thinking about ‘low’ valuations as an absolute number, try thinking about them as a relative measure.

Furthermore, I’ve found that companies outperforming their Industries on earnings, but are ‘undervalued’ to their group in terms of valuations, are great candidates.

So in this week’s screen, I’m looking for companies that:

• are up 10% more than the market over the last 12 weeks
• are trading over $5
• have a minimum average trading volume of 50,000 shares a day
• have shown positive EPS growth over the last 2 quarters that’s greater than their Industry’s average
• have lower P/Es and Price/Book Values than their Industry’s average

There are 11 companies that passed this screen for Wednesday, 7/16/08. Here are 3 of them:

Datascope Corp. [[dscp]]
Lincare Holdings [[lncr]]
South Jersey Industries, Inc. [[sji]]

Try incorporating some of these ideas into your own stock-picking strategies.

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